George S. in Puyallup, Wash., didn’t realize how poorly his mutual fund did last year until he was preparing his annual tax return and checked the results, expecting to see something good.
“There was this big capital-gains payout,” George wrote me in an e-mail, noting that he typically “pays “no attention” to his funds on a daily or monthly basis. “I’m rolling over distributions, so I hadn’t noticed just how big until I have to pay taxes on it. There’s this gain of more than $10,000, so I figured it must have been a good year for the fund, and then I saw that it had actually lost money. Can that possibly be right?”
It’s right, as the Osterweis Fund OSTFX, +0.24% was one of more than 400 stock funds that posted a loss in 2015 but paid out more than 10% of its value in a distribution. For investors like George, who hold the fund in a taxable account, this move generated a big tax bill — insult to injury on a fund that lost 6.3% last year and ranked near the bottom of its peer group.
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For industry observers, this is hardly a surprise, but for individual investors like George to have Uncle Sam reach into their pockets over this is a revelation. It may also be time for a portfolio change, ditching a fund that disappointed for something more tax-efficient.
To see why that is, however, let’s start by showing how this kind of problem happens and why it’s so prevalent now.
Mutual funds are “pass-through obligations,” meaning that tax obligations pass through the fund to shareholders, who are on the hook for their share of taxes due. That means that when a fund manager locks in profits by making a trade, any paper gains create tax liabilities.
A fund can use losses to offset gains and minimize the taxes that are passed along to shareholders, but with the market on a long winning streak after the financial crisis of 2008-09, most losses were exhausted by 2015. While the S&P 500 SPX, +0.36% gained about 1.25% last year, the market was volatile and inconsistent enough to where many managers moved money around.
As a result, investors holding those funds in a taxable account were slugged with a heavy tax bill, despite the mediocrity of their fund. Shareholders must pay the tax even if they never touched the distribution and simply reinvested the payout, which is what George did.
Investors, however, are right to consider what such results say about a fund.
Consider the flip side of the scenario. According to investment researcher Morningstar Inc., 30 stock funds last year reported gains of 8% or more without a penny’s worth of distributions, led by Matthews Japan MJFOX, +3.37% which was rose almost 21%.
For a fund like Osterweis, however, the tax bill had George re-examining the fund and he didn’t like what he saw. It wasn’t just the tax bill, it’s the seven straight years of below-average performance.
“The fund had a good reputation, and it’s up for the 10 years I have owned it,” George told me by telephone. “But now that I look at it more closely, I’m not sure. And when I look at the big tax bill, well, I know I don’t ever want to have that happen again.”
George’s plan is to sell the fund — the good news being that the capital gains bill he is paying on 2015 taxes will reduce any gains he has in the fund.
When he reinvests, George will make tax-efficiency a bigger priority in his selection process. If he likes a fund that shows a tendency to be tax-inefficient, he will look to put it into tax-advantaged or tax-deferred accounts such as a Roth IRA or a 401(k), where the annual distributions don’t create tax headaches.
It’s the right move for a lot of investors. Keeping Uncle Sam out of your pocket for as long as possible is a sound strategy, and if you don’t like what he took from you this year, it’s time to consider whether the funds that gave him an opening to your checkbook are still the best options for your taxable accounts.